ASU 2016-08: Revenue Recognition and Earnings Quality

The Financial Accounting Standards Board (FASB) Accounting Standards Update 2016-08 addresses the topic of "Revenue from Contracts with Customers." This update was issued as part of the broader effort to bring FASB standards into closer alignment with the International Accounting Standards Board (IASB), specifically to converge U.S. GAAP with IFRS standards. The core principle of the update states: "An entity should recognize revenue to depict the transfer of promised goods and services to customers in an amount that reflects the consideration which the entity expects to be entitled in exchange for those goods or services."

To achieve this core principle, an entity must apply the following five steps:

The FASB notes that "the amendments do not change the core principle" but rather "clarify the implementation guidance on principal versus agent considerations."

The updated guidance specifies that when an agent is contracted to perform on the original obligation, the entity must recognize revenue upon completion of performance by the agent. If any revenue — such as fees or commissions — accrues to the entity as a result of arranging performance by the agent, that revenue should also be recognized at the time when the agent completes performance.

Accordingly, the entity must further break down its contractual obligations to determine which obligations are to be met by the agent, to know when the agent has satisfied those obligations, and to have controls in place to assess the transfer of control of goods or the completion of services by the agent. This ensures that revenue is recognized in the appropriate time period. The onus is on the entity to control and track performance, recognize revenue upon completion, and ensure that recognition occurs in a timely manner. In situations where the entity is no longer responsible for performance, it does not recognize revenue from that performance; however, it may still recognize any fees or commissions relating to that performance.

The FASB issued this update to bring U.S. GAAP into closer alignment with IFRS. The amendment did not change the core principles of revenue recognition within GAAP, but it was determined that clarification of the standard's implementation in practice was necessary — particularly where agents are concerned — in order to align with international standards.

This move was part of the larger, long-standing process of convergence between U.S. GAAP and IFRS, which has resulted in a number of changes to GAAP over the years. The need for clarification may have arisen independently of convergence efforts as well: providing guidance on revenue recognition issues is valuable practice in its own right, ensuring that companies recognize revenue consistently and protecting against fraud through the mistiming of revenue recognition.

The primary benefit of ASU 2016-08 is that it provides greater guidance for those preparing financial statements. Prior guidance left certain grey areas with respect to revenue recognition. For example, there may have been pressure to treat different revenues according to different rules, and inventory risk associated with any gap in time between obligation, performance, and recognition. By providing greater clarity, the update reduces that inventory risk.

There are also situations in which the agent has some ability to set prices, which can affect revenue recognition. In those situations, the new guidance provides financial statement preparers with greater clarity as to the specific revenue to be recognized and in what amounts. Having clearer rules with respect to contracts involving agents and third-party performance simplifies the task for preparers of financial statements and should be expected to have a positive impact on revenue quality.